This is the next sub-merging market

January 19, 2017 | Kim Iskyan

By one of the most common definition of “emerging markets,” U.S. markets – in an economy that by many measures is one of the most developed in the world – may soon start to take on emerging market characteristics found in countries like India, Brazil, Russia and Indonesia. And that could be very bad news for U.S. markets.

Political risk expert (and a former boss of mine) Ian Bremmer defines emerging markets as “those countries where politics matters at least as much as economics for market outcomes”. This suggests that the usual suspects that investors look at for signs of market trajectory – economic growth, inflation, interest rates, for starters – are downgraded to only be as important as politics. And in some cases, individual leaders can change institutions, further swaying markets.

Of course, politics always has an impact on markets. Changes in regulation and significant government policy directed at a particular sector, for example, can affect investors in both developed and emerging markets. But it’s a matter of degree: Where do investors get most of their cues about future market trends?

Developed markets used to be easy

It used to be that in developed markets (like the U.S., Europe, and Japan), things were comfortable and easy, and there weren’t many surprises. Politics didn’t matter much to share prices. Economic growth was slow and steady, while stock returns were unspectacular but predictable.

And then there were crazy emerging markets (like most of Latin America, Africa, and much of Asia), the wild west of investing, where anything could happen. Emerging markets grew faster than their developed counterparts, but they were also a lot more volatile.

And bad politics – a cataclysmic political corruption scandal (Brazil not long ago), a dictator who invades a neighbour on a whim (Russia in 2008), regulators in bed with the sectors they were supposed to be looking over (much of Asia in the 1990s) – could erase years of market gains in a matter of days. Politics mattered in emerging markets a lot more than they mattered in more developed markets.

A big submerging market

With U.S. President-elect Donald Trump, politics – and the personal whims of the president-elect himself – are already assuming centre stage. When Trump comments on a company or sector – whether it’s pharmaceuticals, General Motors, Ford and Fiat Chrysler – share prices can rise or fall sharply. For example, shares of Japanese automaker Toyota recently fell 1.7 percent after Trump tweeted that he would force the company to pay a “border tax” if they opened a plant in Mexico. In December, Trump was critical of Lockheed Martin for spending too much money developing the F-35 aircraft. Subsequently, the stock fell 4 percent.

Trump’s tweets have become daily market-moving events. And each Trump tweet triggers thousands of social media filters set up by high frequency trading hedge funds that look to profit from short-term volatility. This causes additional ripples throughout markets.

Historically, since emerging markets were a lot less predictable than developed markets, they were viewed as a lot riskier. So for years, they’ve traded at a lower valuation (like the price-to-earnings ratio) than developed markets. Today, developed markets trade at an average price-to-earnings ratio of 22, compared to a P/E of 16 for emerging markets. The S&P 500 trades at a P/E of 21.

The graph above shows the discount of emerging markets relative to developed markets. If the U.S. begins to behave more like an emerging market, and investors start to treat it more like an emerging market, the valuation of the S&P 500 – currently 34 percent higher than emerging markets – has a long way to fall. Valuations fall when earnings rise (the E of the P/E ratio), or the price (P) falls.

What’s alarming is that the U.S. isn’t the only developed market that looks like it’s on a downward spiral towards emerging market status. The string of crises in the Eurozone in recent years meant that EU policies and politics, the bailout of Greece being one example, set the tone in financial markets for months on end. Brexit, rather than earnings or management or inflation or economic policy, guides much of what happens in British markets. Politics – especially in the form of a powerful, whimsical individual – driving so much of market activity is a recipe for uncertainty.

Markets don’t like that kind of uncertainty. Political risk is a big reason for the valuation gap between developed and emerging markets.

A main reason that a lot of people invest in emerging markets is that they think that over time, the valuation levels (like the P/E) of some emerging markets will rise. As share prices rise, the discount to developed markets would close.

But the opposite could happen: The valuations of developed markets could fall, and close the gap with emerging markets by dropping down to them. Or that discount could remain the same, as valuations of both emerging and developed markets fall – as political risk across all markets rise. And if both valuations drop, history shows us that for every step “developed” markets fall, “emerging” ones fall faster and harder.

If politics continue to play a greater role markets we may see lower stock prices – in the U.S. and markets elsewhere. I think that the end of the Trump rally will play a bigger role in the short term. But in time, investors may get tired of U.S. presidential volatility, and choose instead to stay away.

Kim Iskyan

About Kim Iskyan

Kim Iskyan has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets.

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